Dec. 20 (Bloomberg) -- On either side of a two-lane road
and surrounded by the lush green mountains of Villalba in
central Puerto Rico, stand a pair of manufacturing plants owned
by Medtronic Inc., the world’s biggest maker of heart-rhythm
devices.

Medtronic does more than half of its $16 billion in annual
sales of pacemakers, defibrillators and other devices in the
U.S. It manufactures the equipment at this facility, legacy of a
defunct U.S. tax break designed to encourage investment on the
poverty-stricken island. Yet, Medtronic credits the income to a
mailbox in a Cayman Islands office building.

This isn’t what the U.S. Congress had in mind when it did
away with the federal tax credit for companies’ Puerto Rican
profits. The break was attacked by Republicans and Democrats as
too expensive, and as of 2006, it ended. So Medtronic and other
companies found a solution: They are avoiding taxes by moving
those profits into shell subsidiaries in havens such as the
Cayman Islands, Switzerland and the Netherlands.

“By aggressively shifting income to offshore affiliates,
companies appear to be getting U.S. tax benefits that are equal
to or greater than the ones they did under the old Puerto Rico
tax break,” said Stephen E. Shay, former deputy assistant
secretary for international tax affairs at the U.S. Treasury
Department under President Barack Obama, now a professor at
Harvard Law School. “That almost certainly was not the intent
of the repeal.”

Less Than Half

The profits that used to benefit from the Puerto Rico
credit are now part of a mountain of tax-deferred offshore
earnings totaling at least $1.38 trillion, according to a May
report by JPMorgan Chase & Co. Companies including Apple Inc.,
Google Inc., Microsoft Corp. and Pfizer Inc. are lobbying
Congress for a tax holiday to bring those profits home. Without
such a break, any cash brought back to the U.S. would be taxed
at the federal income-tax rate of 35 percent, with a credit for
foreign income taxes already paid. (To see other articles from
Bloomberg’s coverage of how corporations avoid taxes, click
here.)

Medtronic, based in Minneapolis, paid income taxes in
fiscal 2011 at a rate of less than half that -- 16.8 percent.
That’s also about half Medtronic’s rate under the old Puerto
Rican tax credit.

As the Obama administration and congressional Democrats
take aim at tax breaks for everything from corporate jets to
private-equity manager compensation, the aftermath of the Puerto
Rico credit’s repeal shows just how difficult ending such breaks
can be -- and how determined well-funded tax planners and their
corporate clients are to create new ones.

‘Extraordinary’ Profit

Now the Internal Revenue Service wants to collect some of
those lost taxes. It has identified as a top audit priority the
sophisticated strategies U.S. companies used to shift income
that once benefited from the old tax break in Puerto Rico.

In a memo sent to IRS auditors in February 2007, the agency
called profit levels “extraordinary” in many of the offshore
units created to take over for the subsidiaries that got the
Puerto Rican break. In many cases, those units are generating
“an inordinate amount of the profits, i.e., amounts in excess
of what would be expected, based upon activity,” according to
the IRS memo.

The agency is in a $958 million fight with Medtronic in
U.S. Tax Court over how it reorganized its Puerto Rican
operations, as well as a $452 million court dispute with Guidant
LLC, now a part of medical device maker Boston Scientific Corp.,
over a similar move.

Transfer Pricing

Companies legally move profits offshore using “transfer
pricing,” the system of allocating income between units in
different countries. This lets corporations like Medtronic say
that profit from a $5,000 pacemaker was earned in the Cayman
Islands, even though the device was manufactured in Puerto Rico
and sold in, say, Houston. The company has accumulated $14.9
billion in income allocated to its foreign subsidiaries on which
it hasn’t paid any U.S. income tax, according to its most recent
annual report.

The profit shifting that can stem from transfer pricing
costs the U.S. government an estimated $90 billion a year,
according to Kimberly Clausing, an economics professor at Reed
College in Portland, Oregon. That’s about double the U.S.
Department of Homeland Security’s annual budget and dwarfs the
revenue loss from the various tax breaks currently under
scrutiny. By comparison, changing the so-called carried-interest
provision that allows private-equity managers to pay taxes at a
rate of 15 percent on most of their compensation would only
raise about $2 billion per year for the federal government,
according to the Joint Committee on Taxation.

Cat and Mouse

Under U.S. transfer-pricing rules, offshore subsidiaries
that license rights from their parent companies are supposed to
pay an “arm’s-length” price, or what an unrelated company
would pay. Such transactions often involve the transfer of
intellectual property rights and other so-called intangibles,
for which real world comparisons can be difficult to find. The
IRS objects when offshore subsidiaries pay their parent company
a price that the agency claims is too low, which shifts taxable
profit out of the U.S.

“We are confident that Medtronic has met the requirement
in establishing arm’s-length pricing on all intercompany
transactions,” said Amy von Walter, a spokeswoman for the
company. She declined to comment on specifics of the IRS
dispute.

Medtronic says in court papers that its offshore unit paid
the correct amount for rights moved out of the U.S.

The story of the Puerto Rico tax credit and its aftermath
illustrates the cat-and mouse game companies and the U.S.
government play when Congress tries to close tax breaks. In this
case, even bipartisan support didn’t stop companies from quickly
finding a new legal way to avoid paying taxes.

‘Cautionary Tale’

“It is a cautionary tale,” said Greg Ballentine, an
economist in Washington with Charles River Associates, a
consulting firm that advises companies on transfer pricing.
“There is a very active and aggressive community of tax
advisers out there and they respond to whatever changes are
made, congressional or regulatory. So the IRS is frequently
several steps behind.”

Puerto Rico became a haven for the manufacturing operations
of U.S. companies in the 1960s, when the federal government used
various tax incentives to combat poverty and unemployment on the
island which now has almost 4 million residents.

In 1976, Congress added a tax credit that effectively
exempted from federal income taxes the profits that U.S.
companies attributed to Puerto Rico. The combination of the
break, proximity to the U.S. and plentiful industrial sites
prompted multinational companies to flock to the island, with
medical-device and pharmaceutical makers leading the way,
including Pfizer, Eli Lilly & Co. and Merck & Co.

Tax Holidays

Companies separately negotiated tax holidays from the
Puerto Rican government -- eager to attract jobs to stanch
unemployment -- to be largely exempt from the island’s
equivalent of a national corporate income tax, often paying at
rates in the low-to mid-single digits.

By the mid 1990s, critics led by Texas Representative Bill
Archer, then the Republican chairman of the House Ways and Means
Committee, attacked the break as too expensive, costing the U.S.
about $3 billion a year. In some industries, the tax subsidy was
costing the U.S. as much as $72,000 per job, according to a
study by the federal agency now called the Government
Accountability Office. After a lobbying battle in 1996, the tax
break was repealed, with a 10-year transition period for
companies already benefiting from the credit.

“It pulled the rug from under our feet,” said William
Riefkohl, executive vice president of the Puerto Rico
Manufacturers Association.

Raising $11 Billion

Archer, now a lobbyist for accounting firm
PricewaterhouseCoopers LLP, which represents multinationals on
tax issues, said: “We were determined to let everybody know we
were going to close corporate tax loopholes that clearly stood
out as being appropriate for repeal.”

The Joint Committee on Taxation projected that eliminating
the break would raise close to $11 billion for the U.S. Treasury
over the next decade.

“There was certainly an expectation the companies would
react” after the repeal, said Daniel M. Berman, a former deputy
international tax counsel at the Treasury Department at the time
of the dispute over the tax break. He is now a professor at
Boston University’s School of Law.

Berman was right. After losing the legislative fight, the
tax-avoidance industry of accountants and lawyers sprung into
action. While manufacturing facilities stayed in Puerto Rico,
dozens of companies simply shifted the ownership of those assets
to newly created subsidiaries in tax havens around the world.

Guidant Assets

Guidant, the medical-device maker once part of Eli Lilly
and now owned by Boston Scientific, transferred assets formerly
owned by its Puerto Rico subsidiary to a unit in the
Netherlands, records show.

Guidant says in its Tax Court filings that no taxes were
due on the transfer of assets overseas and that intracompany
royalties were priced properly. A spokeswoman for Boston
Scientific, the second-biggest heart-device maker, didn’t reply
to requests for comment.

One of the leading strategists behind the new tax maneuvers
was Ernest Aud Jr., a veteran international tax lawyer for
accounting firm Ernst & Young LLP in Chicago. Aud advised U.S.
multinationals on how to turn the potential tax jam into an
asset.

“I was probably the architect of a number of the early
conversions,” said Aud, now retired from Ernst & Young. “We
were the ones that made companies aware that there was an
opportunity -- underscore opportunity -- to maybe do better
under” the new arrangement than under the old Puerto Rico
break.

Heart-Rhythm Equipment

Among those taking advantage of that opportunity was
Medtronic. The corporation has grown from a medical repair shop
founded by a Minneapolis engineer in his garage to become the
world’s biggest maker of heart-rhythm equipment. It also makes
an array of other devices, including spinal technologies and
insulin- delivery systems.

Like dozens of pharmaceutical and medical-device makers
that flocked to Puerto Rico, attracted by the various tax
benefits, Medtronic opened its first factory in 1974 and
expanded twice after that.

Grand Cayman Subsidiary

In August 2001 -- about four years before the tax credit
would disappear for good -- Medtronic established a subsidiary
in Grand Cayman, listing an address at an office now used by
Intertrust Group Holding SA, a corporate-services provider that
helps companies establish shell subsidiaries in tax havens.

On paper, Medtronic transferred ownership of its Puerto
Rican assets to this new Cayman unit, called Medtronic Puerto
Rico Operations Co. The Cayman subsidiary is owned by a Dutch
arm, which is in turn owned by a Swiss subsidiary, court filings
show. In 2006, Medtronic transferred some of the Dutch company’s
assets to the unit in Zug, Switzerland, a popular destination
for companies seeking Swiss tax holidays.

The new Cayman entity also entered into an arrangement to
pay royalties to the U.S. parent to use intellectual property
and other rights covering devices it manufactures in Puerto Rico
and then sells back into the U.S. The IRS contends that
Medtronic’s Cayman unit underpaid for those rights, court papers
show, shifting offshore income from U.S. sales.

Offshore Profits

Taxes on such offshore profits are typically deferred
indefinitely until the companies decide to bring the earnings
back to the U.S.

Medtronic’s tax rate has plummeted. In 1995, the year
before congress abolished the Puerto Rico credit, the break cut
4.2 percentage points off the company’s effective tax rate,
helping to lower it to 33.5 percent. By 2011, Medtronic’s tax
rate was down to half that.

Overall, the savings from the low-taxed overseas income
boosted Medtronic’s net income in fiscal 2011 by 30 percent, to
$3.1 billion, based on tax disclosures in the company’s most
recent annual report.

The company has benefited from a “tax incentive grant” in
Puerto Rico, according to the annual report, but doesn’t
disclose that rate. Owning its Puerto Rican assets through a
Cayman shell company lets Medtronic move cash around the world
without being subject to a Puerto Rican withholding tax,
according to two people familiar with such structures.

“The government underestimated how sophisticated and
aggressive multinationals would be in shifting truckloads of
profits out of the U.S.,” Harvard’s Shay said.